Double Trouble

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Double Trouble

MALCOLM GUNN FTII, TEP discusses the conflicting tax requirements of purchaser and vendor on the sale of a fledgling company.

JUST OVER TWO years ago an Inland Revenue Tax Bulletin acknowledged that there was a certain 'tension' between two parts of the capital gains tax legislation: the taper relief provisions and the share identification rules. 'Tension' was a euphemism for 'oh help, the guy who drafted one set of provisions knew nothing about the rest of the legislation and, um, seems to have landed us in a bit of a mess'. It was all sorted out fairly amicably with some Revenue guidance designed to patch it all up and make it look like it was all perfectly thought out in the first place.

This article is about another point of tension in the tax rules. Unfortunately, this tension cannot necessarily be sorted out quite so amicably and, in a worst case scenario, can lead to some very unpleasant tax results.

What I have in mind is the respective positions of vendor and purchaser on a sale of shares in a family company. The problems arise because recent changes in tax legislation have produced considerable conflicts of interest between the parties to the share sale and, far from this being a case of 'Bloggs, you blithering idiot, why didn't you talk to Smith across the corridor when you drafted these rules', we can assume that Bloggs and Smith at Somerset House knew perfectly well what each other was up to.

The vendor

The current taper relief rules produce the lowest rate of CGT for almost 40 years for those selling shares in a trading company. No, this is not turning into a party political broadcast; that statement is actually true! What is more, this low rate: 10% for a higher rate taxpayer, is available after just two years of ownership of the shares.

This favourable scenario was undoubtedly designed to assist those forming fledgling businesses, particularly in the technology sector where the main assets of the business will be in its intellectual property. It was Gordon Brown's lucky break for those wearing their baseball caps back to front, and saying 'cool' to everything. More staid members of society running ordinary trading businesses, buying and selling goods, do not commonly set them up and sell them within two years as they require long term investment to develop and grow.

Another feature of setting up and selling a business within two years is that the sale will very often be in the form of an earn-out, because no business will have realised its full potential within two years of inception. The baseball cap might be worrying, but still there will be great hopes for the future and, by the same token, risks that those hopes will not be realised. In financial terms, both parties to the share sale will therefore find an earn-out to be the ideal way forward. If the future profits materialise, the vendor will participate in them, but if they do not materialise the purchaser will not be out of pocket.

Earn-outs in a nutshell

The tax provisions relating to earn-outs have been progressively revisited by the Revenue over the years. The original principle, based on the decision in Marren v Ingles [1980] STC 500 was that at the time of sale, the CGT calculation involved sale proceeds which comprised two elements: the immediate consideration and a valuation of the right to deferred consideration. Tax was payable immediately on that combined total, insofar as it produced a gain over base cost. As the earn-out payments were received, there was a part disposal of the earn-out right, taking its base cost to be the valuation included in the year of the original disposal. These part disposals might produce gains or losses, and it was a winning position all round for the Exchequer. If there were gains, tax was collected, and if there were losses, there was no recovery of the tax already paid.

After a very long and pregnant pause, this was recognised as being an unjust result and capital losses on earn-out rights became capable of carryback for set off against the gain which arose on the original disposal of the shares. It is strange how quickly anomalies working against the Revenue get sorted out, but those working against the taxpayer take a little longer!

Provided that there is no cash element in the terms of the earn-out, it is also possible to structure the deal so as to maximise taper relief and roll over into any new shares acquired. The mechanism by which this is achieved is TCGA 1992, s 138A, which treats the earn-out right as being a chargeable security for CGT purposes. There will therefore be a paper-for-paper rollover on the sale of the shares into the earn-out right, and then from the earn-out right into the shares or loan notes in the purchaser company as and when the earn-out comes to fruition. This will enable the business taper relief holding period to continue if the purchaser is an unquoted trading company, or in the case of a quoted company if the vendor is to have any employment, whether full time or part time, with the purchaser company.

In situations where taper relief is already at its maximum level, it will be advantageous to structure the sale so that loan notes are received which are qualifying corporate bonds. This freezes taper relief at the time when the bonds are issued, while leaving the gain to be charged when it actually materialises on the redemption of the bond.

All in all, earn-outs on share sales now offer plenty of scope for the advisers to the vendors to maximise the taper relief (and their fees) and minimise the tax bills.

The purchaser

Looking at the purchaser's side of the transaction, no purchaser was ever desperately keen to buy existing shares. Despite all the endless pages of warranties and indemnities which would be given, he was still buying a secondhand asset which might contain all manner of obligations and liabilities yet to come out of the woodwork.

In the case of fledgling businesses which the current taper relief régime apparently wishes to encourage, the purchaser will now be even less inclined to buy the shares. If he can buy the business itself, the cost is likely to represent largely goodwill and the purchase of it now qualifies for a full tax deduction on accountancy principles under the intellectual property régime. Furthermore, it is exempt from stamp duty.

On the stamp duty front, if there are other assets in the company, such as a property, a purchase of the assets instead of the shares would carry the significant drawback of 4% stamp duty. However, it will be unusual for the client I have described to have a valuable property in the business. The valuable property will more likely be bought with the sale proceeds.

The conflict of interest

Purchasers therefore have even greater incentives to buy the assets rather than the shares in a fledgling business. It immediately becomes apparent how Bloggs and Smith have now created a situation of 'tension' between the parties who will have conflicting objectives. Pity the chap with the baseball cap, because it is more likely that the views of the purchaser may carry more weight than his. In a fledgling business, the vendors may be throwing all their cash into the new venture and they may welcome the additional financial support which a wealthy purchaser would provide. There will also be the hope of early release from their financial problems.

As for the purchaser, he can just as easily walk away and find some other enterprise to invest in, so he may be calling the shots.

Sale of assets

In these cases, the vendors may well therefore have to accept that the sale of the business is the only way to secure an acceptable deal. However, the tax consequences for the vendor will not be particularly wonderful. They will be left with a company which has a right to future unascertainable consideration and the company will serve little purpose other than to increase tax liabilities, unless a new business venture is to be commenced within it. All the very useful earn-out provisions which have been achieved by much lobbying down the years will fall out of the picture.

The loss relief provision at TCGA 1992, s 279A will not apply as it cannot be claimed by companies; nor can it be claimed if the earn-out right is assigned out of the company to the shareholders, as in that event it will become a secondhand right and the relief will not apply. Also the paper-for-paper provisions of TCGA 1992, s 138A will not assist because, for those purposes, there must be a disposal of shares in exchange for an earn-out right. A disposal of assets offers no paper-for-paper rollover.

One will therefore be left with the company to collect its consideration for the disposal and more than likely incur 30% corporation tax on the amounts received. The shareholders will want to have these funds distributed to them, unless they have a future use for them in the company. If they are distributed by way of dividend, further tax amounting to one quarter of the distribution is likely to be payable, giving a combined total tax liability of 47.5% of the consideration received from the vendor. Whatever you may have heard in recent Budget statements about low rates of tax suddenly begins to sound like pie in the sky.

More misery

The misery does not end there. The accountants will need to decide whether any further amount should be credited to profit and loss account in respect of the right to future payments. The intellectual property régime raises tax liability on accountancy principles and so a credit to profit and loss with a provision in debtors will add to the initial corporation tax liability with no immediate cash sum to finance it. It is to be hoped that the accountants will get enough encouragement to decide that the concept of prudence requires that little or nothing is brought into the profits and loss account, but this will depend on all the circumstances of the case.

If it is decided to accumulate the proceeds of the sale of assets and the earn-out consideration in the company and liquidate it in due course, the taper relief on the shareholdings could easily become heavily tainted. If one assumes a business period of two years, followed by a three-year earn-out period in which no business is conducted, the combined total tax liability on the company and its shareholders will again be in the region of 47%: 30% on the company and 17% tax on capital gains after taper. 47% does not sound to me like the lowest rate of CGT for 40 years.

The taper position might be greatly assisted by placing the cash on deposit within the company, in which case the provisions of TCGA 1992, Sch A1 para 11A might apply, treating the company as inactive so that the period following the business sale will not count for taper relief. This could get the combined tax liability down to about 37%, but at the price of the shareholders not getting their hands on the cash in the company for some years, which is likely to go down like a lead balloon. They will definitely not say 'cool' to that. There is also no certainty that para 11A will apply. The Revenue's views are set out in Tax Bulletin 61 and, because the company in question holds a valuable earn-out right, it does not strictly satisfy the Revenue's tests.

The alternative will be to wind up the company as soon as possible and distribute the available cash and earn-out right to the shareholders. Unfortunately, this does not do much for the tax position either. Leaving aside any accounting issues as regards bringing in a closing value for the distribution of the earn-out right, there will still be 37% combined tax liability on the immediate cash payment distributed out to the shareholders in liquidation and the payments received later on under the earn-out right are likely to get no taper relief, being non-business assets; so the tax on them may well be 40%. All in all, the hopes raised for 10% taxation for disposals of fledgling businesses suddenly seem to be about as remote as the future abolition of income tax.

What can be done?

Are there any solutions to this tax nightmare? The short answer is that the company was never a good idea, and any new business of this type which might be sold in the Chancellor's two-year timescale is best conducted through a partnership or as a sole trader. This completely obliterates the two tiers of tax which the corporate structure introduces and allows the favourable taper relief régime to operate for the benefit of the individual owners. Those advising new businesses should bear this firmly in mind.

For those who have already gone down the corporate route, the choices for tax minimisation will be between reinvesting the cash proceeds within the company in an appropriate manner, or adopting some tax avoidance techniques. In the case of a sale of goodwill out of a company which was created after 1 April 2002, the sale falls under the intellectual property régime, and so it is not possible to use the standard CGT rollover provisions into other business assets. The reinvestment will have to be into new intellectual property, including an acquisition of goodwill and this is unlikely to be what the shareholders have in mind.

On the other hand, if the goodwill of the company was created before April 2002, the disposal will fall into the corporation tax or capital gains régime and a rollover into new assets will be possible. These could be assets of an investment nature, but which qualify for rollover relief, a typical example being furnished holiday lettings; remember that properties for these lettings do not have to be bungalows by the sea, but they can be any properties, large, small, cheap or expensive, anywhere in the UK.

There may in fact be no need to try and extract all the funds from the company. It might suit some vendors to continue it as a family investment vehicle, and perhaps use it in due course to deal with the double layer of tax liability which corporate vehicles otherwise bring about.

Tax avoidance

Most, however, will want to disentangle the cash from the company and the high tax cost involved will lead them to consider tax avoidance.

Avoidance techniques might include taking the cash out by way of dividend during a period of non-residence, or adopting one of the currently available capital loss schemes. Non-domiciliaries have many more choices available to them.

It has to be said that this is yet another area where individuals only engage in artificial tax avoidance because they feel badly victimised by the tax system. With all the current debate about morality and tax avoidance, these individuals will feel that the morality argument is firmly on their side, despite all the hot air on the topic which comes out of Parliament these days. Much the same applies to all the thousands of homeowners who in recent years have gone in for inheritance tax saving schemes in relation to their residences. Many of them have only done this because asset inflation has suddenly created potential inheritance tax liabilities which were never there before. Their view is that the Exchequer is benefiting from a windfall which it ought not to have and, worse still, which it now regards as something to be preserved and protected.

I was never the world's top advocate of either tax avoidance schemes or the great morality debate, but recent projects have produced some new perspectives on both these issues. The Pre-Budget Report included a discussion paper on 'Small companies, the self-employed and the tax system' and this contains some remarks acknowledging the adverse tax effects where a small company sells its business. This is a golden opportunity for representations to be made on the point.

Malcolm Gunn is a tax consultant with Haarmann Hemmelrath; e-mail Malcolm.Gunn@haarmannhemmelrath.com; telephone 020 7382 4874.

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